In finance, an option is a contract between a buyer and a seller that gives the buyer the right—but not the obligation—to buy or to sell a particular asset (the underlying asset) at a later day at an agreed price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option gives the buyer the right to buy the underlying asset; a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire.

The theoretical value of an option can be evaluated according to several models. These models, which are developed by quantitative analysts, attempt to predict how the value of the option will change in response to changing conditions. Hence, the risks associated with granting, owning, or trading options may be quantified and managed with a greater degree of precision, perhaps, than with some other investments. Exchange-traded options form an important class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trading and clearing arrangements with each other. Another important class of options, particularly in the U.S., are employee stock options, which are awarded by a company to their employees as a form of incentive compensation. Other types of options exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply across all financial options.

Contract specifications

Every financial option is a contract between the two counter parties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:

• whether the option holder has the right to buy (a call option) or the right to sell (a put option)
• the quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock)
• the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise
• the expiration date, or expiry, which is the last date the option can be exercised
• the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount
• the terms by which the option is quoted in the market to convert the quoted price into the actual premium–the total amount paid by the holder to the writer of the option.